The frenzy and tumult associated with initial public offerings (IPOs) by young,
high-tech companies during the Nasdaq bull market of 1998 to 2000 first
fascinated America and then, as the market soured, provoked massive
recriminations, including enforcement proceedings by the Securities and
Exchange Commission (SEC) and even a criminal investigation by the United
States Attorney for the Southern District of New York. Although the criminal
investigation was ultimately dropped, the SEC has negotiated a $100 million
settlement from Credit Suisse First Boston (CSFB) of charges brought by
the SEC and the National Association of Securities Dealers (NASD) that the firm
demanded excessive or unlawful brokerage commissions in return for IPO
allocations. The SEC also continues to investigate allegations that various
underwriters manipulated stock prices by tying IPO allocations to mandatory
purchases of the same stock in the secondary market (a practice known as
"laddering"), and numerous private class actions are pending that seek damages
for investors who purchased IPO stocks in the secondary market.

But what do these investigations prove, beyond that some firms may have broken the law? For many, the characteristics of IPOs that most attracted public and media attention -- namely, the intense competition to receive allocations of shares in "hot" or oversubscribed offerings and the extraordinary first-day price spikes when shares sometimes rose 500 percent (or even more) above their offering price during the first day of trading -- also indicate that something is seriously wrong, or at least dysfunctional, within the IPO market.

John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia
University Law School. This article was written while Professor Coffee was
also serving as the Joseph Flom Visiting Professor of Law at Harvard University
Law School.

Far less agreement exists, however, on what, if anything, is wrong. Some see
the late 1990s era in moralistic terms as reminiscent of the period preceding
the 1929 crash, when stock promoters foisted worthless securities on an
unsuspecting public. Others view the same evidence as demonstrating that the
IPO market is economically dysfunctional and favors the interests of financial
intermediaries over those of young companies seeking to raise capital.
Finally, defenders of the system maintain that the recent public outcry only
repeats the familiar pattern of searching for a scapegoat whenever the stock
market crashes. They argue: "If ain't broke, don't fix it."

· The First-Day Price Spike Puzzle

To resolve (or, at least, understand) these differing perspectives, it is
useful to begin with the most salient fact about IPOs: namely, the first-day
price spike. During 1999 and early 2000, the average IPO rose roughly 100
percent from its initial offering price to the close of trading on the first
day. By definition, price spikes occur because the offering is oversubscribed
-- that is, the underwriters have solicited "indications of interest" from
potential buyers amounting to many times the number of shares that the issuer
(i.e., the company "going public") wishes to sell. Often, the underwriters may
solicit non-binding offers representing five or even ten times the shares that
are to be sold. The underwriters "build their book" in this fashion in part
because all offers to purchase by investors are legally nonbinding and
revocable up to the point at which the SEC approves the issuer's registration
statement and declares it "effective." Hence, the underwriters know that even a
seemingly healthy 2:1 ratio of offers-to-buy to shares-to-be-sold could
suddenly evaporate. Rationally, they wish to maximize this oversubscription
ratio as a protection against a sudden shrinkage in demand if a substantial
group of buyers were to back out at the last minute.

Understandable as this motivation is, it results in the underwriters
possessing material nonpublic information, which they typically do not share
with either the issuer or the public investors: namely, the size of this
oversubscription ratio. For example, if this ratio were 7:1, the underwriters
could reasonably expect that the offering would be a "hot" one with a sharp
price spike in the immediate aftermarket, as investors who offered to buy the
stock but did not receive an allocation (or were allocated less than they
wanted) were forced to buy the stock after it started trading.

· The Allocation Issue

This knowledge faces the underwriters with a critical choice: They could
prorate the stock in a "hot" or oversubscribed offering among all customers (or
use some other equitable allocation formula), or they could allocate the stock
largely to their preferred customers. Almost universally, underwriters choose
the second option. Why? The simple answer is that large institutional investors
implicitly pay for receiving priority in the allocation of "hot" offerings by
directing their brokerage business to the major underwriters. For example, a
large mutual fund may trade millions of shares in the secondary market each
year. It could direct this brokerage business to a cheap discount broker, or
it could negotiate a somewhat higher commission rate with a broker dealer that
was also a major underwriter in return for a priority in the latter's IPO
allocations. Some believe that there is a known "going rate" -- i.e., a
minimum amount of brokerage business necessary to obtain an IPO allocation. But
even if no such set rate exists, norms of reciprocity have long characterized
the underwriting business. Indeed, using allocations to obtain brokerage
business is probably what makes the IPO business very profitable for major
underwriters, because for many years the major underwriters have all charged
approximately the same underwriting commission (roughly 7 percent of the total
offering -- a seemingly non-competitive price that has at times concerned the
Justice Department's Antitrust Division, even if no conspiracy has ever been
proven).

Retail investors may resent their relative exclusion from IPOs, but no rule of
the SEC or the NASD requires that every customer receive an equal opportunity
to buy "hot" stock. Indeed, across other fields of business, merchants
characteristically reserve goods in scarce supply for preferred customers.

· Pushing the Envelope

The competition for IPO allocations intensified in the late 1990s, precisely as
the first-day price spikes became larger and larger. As IPO allocations became
more valuable, practices changed in several respects.

First, newer varieties of institutional investors -- most notably, hedge funds
-- sought to obtain IPO allocations. Typically, they had paid far lower
aggregate annual brokerage commissions to underwriters than had much larger
mutual funds, but as the IPO market heated up in the late '90s the hedge funds
were willing to compensate underwriters for this shortfall by paying
considerably higher brokerage commissions on a per-share basis. For example,
some hedge funds allegedly paid extraordinarily high commissions on individual
transactions (say $50,000 on a $500,000 transaction) in order to earn a credit
that could be applied to IPO allocations. To federal prosecutors who for a time
were investigating these transactions, this looked suspiciously like commercial
bribery: that is, exchanging a cash payment for an allocation.

Second, some underwriters allegedly began asking institutional clients to
share their first-day trading profits with the underwriter (for example, by
rebating one-third of their first-day profits). These practices did violate SEC
or NASD rules, which preclude brokerage firms from sharing in their clients'
profits or charging commissions in excess of 5 percent. The irony here is that
these rules were designed to protect unsophisticated retail customers from
overreaching by brokers, whereas the much more sophisticated hedge funds
arguably did not need or want such paternalism (because if they could not pay
such "excessive" commissions, they would likely be denied or reduced in their
IPO allocations).

· Who Is the Victim?

Although allegations of bribery and suspiciously large brokerage commissions
have dominated the media's coverage of the IPO allocation process, two other
injuries may be more serious, if less visible. First, the corporate issuer may
suffer the clearest injury when there is a substantial first-day price spike.
Assume a first-time issuer goes public at a price of $10 per share (this means
in reality that the underwriters buy the stock from the issuer at $9.30 and
resell it to their preferred clients at $10). The first trade in the secondary
market on the day of the offering occurs at $15 per share (a 50 percent runup),
and by the end of that first day, the stock has risen to $45 per share (a 350
percent increase). If one million shares are now outstanding, the issuer's
market capitalization at the end of the first day is thus $45 million -- but
only $9,300,000 has been raised by the issuer. In other words, approximately 20
percent of the value of these securities has gone to the issuer to fund its
growth and expansion, while 80 percent has gone to financial
intermediaries. If the purpose of the equity market is to permit companies to
raise capital to fund their economic expansion, this is a very costly form of
financing.

Why doesn't the issuer object to this underpricing and insist that the
underwriters price heavily oversubscribed offerings higher? For example, if
the offering were oversubscribed by, say, a 7:1 ratio at a price of $10 per
share (as in the preceding example), the issuer would realize that the
underwriters could probably sell out the offering at $15 or even $20 per share,
thus realizing more capital for the issuer and less profit for speculators.
This puzzle of why so much money is seemingly "left on the table" by the issuer
has long fascinated financial economists, who have found that the average IPO
is underpriced by $9.1 million (an amount roughly twice the fees of the
underwriters).1 The answer to this puzzle cannot be that IPO issuers
are systematically stupid or naïve because the typical board of directors
of a company going public usually includes several sophisticated venture
capitalists.

Several different factors may explain why the underpricing of IPOs has long
been a pervasive phenomenon. First, both issuers and underwriters face very
high liability under the federal securities laws if the stock price in an IPO
declines below the initial offering price. For this reason, they may consider
it safer to underprice the offering to a degree in order to avoid the special
standards of liability that apply to registered public offerings.

Second, both the issuer's management and the underwriter may face conflicts of
interest that lead them to knowingly accept underpricing. Obviously, the more
the offering is underpriced, the more valuable the IPO allocations become and
the more the underwriters can demand that institutions use their brokerage
services in return for them. For the issuer's management, the conflict is more
complex and lies in the fact that they typically cannot sell their own shares
in the company until six months after the IPO. Almost uniformly, underwriters
negotiate a "lockup agreement" under which insiders (both management and
venture capitalist shareholders) agree not to sell any of their shares until
the expiration of a six-month lockup period that begins on the offering date.
This both assures investors that management is not "bailing out" of the company
and also intensifies the first-day price spike (because in the typical case the
insiders own a majority of the stock and thus the lockup substantially
restricts the short-term supply of stock available in the secondary market).
Given that its own stock is locked up, management's personal focus may be on
the likely value of the stock in six months time when they can sell their own
shares. Both the conventional wisdom and the empirical research holds that a
sharp first-day price spike is the best means of maximizing this later value
because it creates a momentum in the stock's price that builds up to the lockup
expiration date. That is, the greater the first-day price spike, the more that
the firm will attract the attention of securities analysts and maximize its
share value as of the end of the lockup period.2 Nonetheless, from a
public perspective, the social price of benefitting management in this fashion
by intentionally underpricing the stock is that the firm raises less capital
and at a more expensive cost.

· Other Victims: Retail Investors

Another constituency may be even more adversely affected by current practices.
This group consists of those investors who do buy in the secondary market,
either on the first trading day or shortly thereafter. Typically, these are
persons who did not receive an IPO allocation (or only a small one). The best
known empirical regularity about IPOs is that the issuer's stock price tends to
decline at some point during the year following the initial price spike, often
to a level below the initial offering price. Thus, those who buy in the
secondary market immediately following the IPO tend to lose.

Although this typical post-offering price decline may seem surprising, the
reasons underlying it are logical. First, there is a systematic imbalance
between supply and demand in the period following the IPO, with supply being
deliberately restricted. Supply is constrained, first, by the lockup
agreements that keep management's and the other insiders' stock off the
market, and second, by "anti-flipping" rules. "Flipping" refers to the practice
of quickly reselling IPO stock in the immediate aftermarket, often after a
holding period lasting no more than a few days -- and sometimes much less.
Underwriters dislike flipping because it creates downward price pressure on the
stock (and disappoints the issuer's management, their key constituency). Thus,
they restrict flipping by telling most investor clients that if they flip, they
will be denied the right to purchase shares in future IPOs for at least a
defined period (put into the "penalty box," in the vernacular). Brokers whose
clients flip may also be subjected to financial penalties imposed by the
underwriter by contract.

These anti-flipping rules are not generally applied to institutional
investors, who simply have too much economic leverage to be disciplined in this
fashion. As a result, in the immediate aftermarket, only institutions are
freely permitted to sell, and hence the imbalance between supply and demand can
become extreme, thereby contributing to the intense character of the price
spike.

Although anti-flipping rules have been upheld by the courts (with the SEC's
encouragement) and lockup agreements seem unquestionably valid and enforceable,
other practices that developed in the late 1990s are legally suspect and
probably unlawful. Chief among these are "tie-in" arrangements whereby the
underwriter gives an institutional investor the allocation that it seeks (or
most of it) on the condition that the institution will buy additional shares at
an inflated price in the IPO aftermarket. For example, suppose in a hot
offering in which the initial offering price will be $10 per share, the
underwriter agrees to give an institutional investor the full 50,000 share
allocation it wants if it agrees to immediately purchase 25,000 shares at a $15
price on the commencement of trading. Alternatively, the underwriter may
demand that the institution buy 5,000 shares at each one-point price increment
reached by the stock during the first day of trading. Such prearranged
agreements to purchase stock at prices above the offering price artificially
manipulate the market, in the SEC's view, and are the subject of a continuing
SEC antifraud investigation. The victims of these practices are, of course,
the retail investors who are buying at inflated prices that do not reflect the
natural equilibrium of supply and demand.

· Prospects for Reform

Even if these fraudulent practices can be restricted, the IPO market will still
remain one in which the short-term price is not the product of the normal
interaction of supply and demand, because supply has been artificially
restricted by lockup agreements and anti-flipping rules. As a result, price
spikes in oversubscribed offerings should persist, and are likely to be
followed by a price decline once these restrictions on supply lapse. For the
present, investors have been sufficiently repelled by the bursting of the
Nasdaq bubble that few IPOs are so oversubscribed as to produce any price
spike. But in the future, the familiar pattern may reappear.

One market development could change this pattern. A few underwriters (most
notably W.R. Hambrecht & Co.) are seeking to introduce an auction
procedure for the pricing of IPOs. This procedure would price the stock at the
highest price at which the entire offering could be sold. Thus, it would end
underpricing and automatically give the retail investor an equal opportunity to
participate in IPOs. Auction pricing faces strong opposition, however, both
from underwriters (who want to exchange allocations for brokerage business) and
from institutional investors (who obviously prefer to participate in
underpriced offerings). Also, while auctions might ensure higher prices for
issuers, there would be an increased risk of legal liability if the stock price
dropped within the following year, and managements might receive lower prices
for their own shares on the expiration of their lockup agreements. Thus, the
prospect for sweeping changes in the market still seems remote.

What changes or reforms are likely from the SEC? Beyond enforcing existing
laws, it is very unclear whether the SEC will seek to introduce any new rules
or regulations. Inherently, the SEC's authority is to prevent fraud and
require full disclosure. Thus, in all likelihood, it does not feel authorized
to impose an auction mechanism on the IPO marketplace. Although the SEC
probably also lacks authority to adopt an equal opportunity rule for the
allocation of IPO stock, the NASD and the stock exchanges do have broader
authority and arguably could impose such rules on underwriters. But any
attempt to do so would likely set off a major lobbying battle.

What, if anything, should be unsettling to the average citizen in all these
developments? Of course, indications of fraud or manipulation, particularly
when committed within powerful and respectable institutions, should be
disturbing. But the evidence is not yet in, and the extent of such misconduct
cannot be estimated reliably at this point. The more serious policy problem
surrounds the question of whether the contemporary IPO market fulfills the
classic function of a market: namely, to link buyers and sellers at the lowest
possible cost. Arguably, rather than linking capital-hungry corporations with
potential providers of capital at low cost, the contemporary IPO market is
designed more to benefit financial intermediaries (i.e., underwriters and those
institutional investors who receive IPO allocations and then flip these shares
in the short term). No consensus exists today on whether the IPO market is
inefficient or otherwise imposes unnecessary costs on capital formation, but a
lively and important debate seems likely to continue.